The interest rate projections released after the January Federal
Open Market Committee (FOMC) meeting were another step toward increased
Fed transparency. As described in a previous article, the additional
information about FOMC participants' views on appropriate policy
should help shape market participants' expectations for future
policy actions. In the projections, each member of the FOMC described
how he or she would conduct interest rate policy, given economic
conditions in January and how they expect conditions to develop going
forward. However, connecting the dots between the future interest rate
policy and the economic data still leaves room for interpretation. Can
we ascertain some of the important variables that Committee members are
implicitly responding to?

Estimating a Taylor rule can help with the interpretation. The
original Taylor rule was created in 1993, and it defined a relationship
between the federal funds rate, the rate of inflation, and deviations of
economic output from its potential. Because the FOMC has made it clear
that its dual mandate dictates that both inflation and unemployment must
be considered when conducting monetary policy, we modify the original
rule so that the fed funds rate depends on inflation (which we take to
be core PCE inflation) and unemployment. Implicit in an unemployment
rate is the idea of a gap between the current and the optimal level of
employment.

Our version of the rule tracked the actual funds rate fairly
closely, until interest rates hit near zero and could not be lowered any
further. This suggests that in the past the Committee has used something
akin to this rule as a guidepost for monetary policy.

A relevant question now is whether such a rule roughly describes
Committee members' views on appropriate monetary policy going
forward. To get at that question, we use the FOMC's January
projections for inflation and unemployment to produce a federal funds
rate path into the future. We estimate the funds rate path from the
first quarter of 2012 through the second quarter of 2017 in the chart
below (Note: this time period is used to match the definition for the
longer-run projections, representing five or six years ahead).

Because of the range of projected economic outcomes, we can produce
a range of rule-implied federal funds rate paths. These paths, of
course, are what the Taylor rule predicts the funds rate would be if
FOMC members could set negative interest rates. The bottom of the fan
represents the Taylor rule being calculated with the highest projected
level of unemployment and the lowest projected rate of core inflation in
any given period. (Note: we are implicitly assuming that the Committee
member with the highest unemployment projection had the lowest inflation
projection. This clearly may not be the case.) Similarly, the top of the
fan bakes in the opposite extremes in the projections for those two
variables. The darker bands do a similar exercise with the central
tendency of the projections, which simply excludes the three highest and
three lowest projections for each variable in each year. Finally, the
median path is just the midpoint of the central tendency projections.

The value in this exercise is comparing the results from the Taylor
rule to the FOMC participants' interest rate projections. The
January FOMC statement, which reflects the Committee's consensus
view, said that "economic conditions are likely to warrant
exceptionally low levels of the federal funds rate at least through late
2014." According to the median path predicted by our unemployment
Taylor rule, the first fed funds rate increase would occur in the second
quarter of 2014.

We also have the entire histogram to work with, which gives the
whole range of participants' expected first rate increases. The
very early end of those projections shows the first possible rate
increase in 2012, a date projected by three Committee members. Our
unemployment Taylor rule also predicts the earliest rate increase to
occur in the fourth quarter of 2012. The timing of the latest exit from
near zero interest rates, as projected by FOMC participants, was in
2016. Again, the unemployment Taylor rule predicts the same year.

[GRAPHIC OMITTED]

[GRAPHIC OMITTED]

If we knock off the top and bottom three projections in the
histogram, we see that the central tendency range is tighter, centered
around 2014, with three participants each on 2013 and 2015. The
unemployment Taylor rule does a decent job matching this central
tendency. From the fan chart, the bottom of the central tendency
predicts a rate increase from the zero bound in the third quarter of
2013, the same year the central tendency in the histogram would imply.
If we look at the top of the central tendency, the Taylor rule and the
FOMC projections both show an exit beginning in 2015.

It is important to keep in mind that these are very rough
exercises. Obviously no Committee member would literally think that
appropriate monetary policy would be to slavishly follow such a rule.
There are a myriad of other factors that Committee members would also
look at. Nevertheless, this exercise illustrates that such a rule
roughly captures many Committee members' views of appropriate
monetary policy.

Appropriate Timing of Policy Firming
Number of participants
2012 3
2013 3
2014 5
2015 4
2016 2
Source: Federal Reserve Board.
Note: Table made from bar graph.
January 2012 FOMC Projections and Taylor Rule Predictions
Bottom of Bottom of Median Top of Top of
range central central range
tendency tendency
The timing of
the first
rate
increase,
according to:
January 2012 2013 2014 2015 2016
SEP
projections
Unemployment 2012:Q4 2013:Q3 2014:Q2 2015:Q3 2016:Q1
Note: The centra! tendency excludes the three highest and three
lowest projections for each variable m each year. The range
includes all participants' projections, from lowest to
highest, in that year. The dates in the Summary of Economic
Projections (SEP) are only reported as annual numbers, so the
quarter in which the rate increases would occur are unknown.
Sources: Federal Reserve Board; January 2012 Summary of
Economic Projections (SEP); Bureau of Economic Analysis;
Bureau of Labor Statistcs; authors' calculations.

02.17.2012

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